report to the european commission - esma...regulation (eu) 2019/834 (hereinafter ‘emir refit’)...
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17 December 2020 | ESMA70-151-3248
Report to the European Commission Report on the Central Clearing Solutions for Pension Scheme Arrangements (No. 2)
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17 December 2020
ESMA70-151-3248
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Table of Contents
1 Executive Summary ............................................................................................................ 6
2 Introduction ......................................................................................................................... 8
3 Regulatory context of this report ....................................................................................... 10
4 Public consultation ............................................................................................................ 11
4.1 Presentation ............................................................................................................... 11
4.2 Participation ............................................................................................................... 11
5 Derivatives as an integral part of PSAs’ investment approach ........................................ 12
6 Central clearing requirement applied to PSAs’ derivatives portfolios .............................. 17
6.1 Benefits and Reasons to clear .................................................................................. 17
6.2 Access to clearing...................................................................................................... 18
6.3 Current & projected cleared volumes of PSAs ......................................................... 19
6.4 Impact on Portfolios allocations................................................................................. 20
6.5 Other challenges........................................................................................................ 21
6.6 Estimated impact ....................................................................................................... 23
6.6.1 In terms of baseline Initial Margin and possible add-ons .................................. 23
6.6.2 In terms of cash holdings ................................................................................... 23
6.6.3 In terms of yield drag .......................................................................................... 24
6.7 Increased Liquidity Risk in stressed conditions ........................................................ 25
6.7.1 Estimated impact of a 1% shift in rates to VM across EU PSAs ....................... 26
7 Exemption from clearing for PSAs .................................................................................... 28
8 A combination of improved available services ................................................................. 31
8.1 Pre-conditions for a workable solution ...................................................................... 31
8.2 Collateral transformation services by clearing members .......................................... 32
8.3 The market-based repo solution ............................................................................... 34
8.4 Repo clearing via Direct or Sponsored Membership models ................................... 37
8.4.1 Presentation of the model .................................................................................. 37
8.4.2 Benefits of the model for PSAs .......................................................................... 37
8.4.3 Limitations of the model ..................................................................................... 38
8.4.4 Offer in the EU and current take-up by PSAs .................................................... 39
8.5 Proposed regulatory measures ................................................................................. 40
9 The Covid-19 crisis impact on bilateral and cleared markets .......................................... 42
10 Access to alternative emergency liquidity arrangements ............................................. 43
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11 Conclusion ..................................................................................................................... 43
12 Next steps ...................................................................................................................... 45
13 Annex - EMIR Refit articles relevant to the Clearing Obligation for Pension Scheme
Arrangements ........................................................................................................................... 46
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Acronyms
AIF Alternative Investment Fund
BCBS Basel Committee on Banking Supervision
CCP Central Counterparty
CRR Capital Requirement Regulation
CSD Central Securities Depository
EBA European Banking Authority
EEA European Economic Area
EIOPA European Insurance and Occupational Pensions Authority
EMIR European Market Infrastructure Regulation
ESMA European Securities and Markets Authority
ESRB European Systemic Risk Board
FC Financial Counterparty
GDP Gross Domestic Product
HQLA High Quality Liquid Asset
ICMA International Capital Market Association
IM Initial Margin
LR Leverage Ratio
NFC Non-Financial Counterparty
OTC Over-The-Counter
PSAs Pension Scheme Arrangements
SFT Securities financing Transaction
UCITS Undertakings Collective Investment in Transferable Securities
VM Variation Margin
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1 Executive Summary
Reasons for publication
Regulation (EU) 2019/834 (hereinafter ‘EMIR Refit’) entered into force on 17 June 2019 and
introduced a number of amendments to EMIR, one of them being a further extension of the
exemption from the clearing obligation for pension scheme arrangements (PSAs). This
extension was introduced because of the challenges that PSAs would face to provide cash
for the variation margin calls related to cleared OTC derivative contracts.
This extension however goes hand in hand with the EMIR Refit objective of also ensuring
that progress is made by the relevant stakeholders in addressing these challenges and for
PSAs to clear their contracts as soon as possible. As part of this latter objective, EMIR Refit
provides that ESMA, in cooperation with the European Banking Authority (EBA), the
European Insurance and Occupational Pensions Authority (EIOPA) and the European
Systemic Risk Board (ESRB), should prepare a report every year as long as the exemption
still applies, as input for the Commission’s own report, assessing whether viable technical
solutions have been developed for the transfer by pension scheme arrangements of cash
and non-cash collateral as variation margins and the need for any measures to facilitate
those technical solutions.
ESMA’s first report was published in April 2020 and served as the basis for conducting a
public consultation until June 2020. The public consultation aimed to collect views from a
broad range of stakeholders, as well as to collect updated data on European PSAs’ portfolios
and on the quantitative impact of moving their OTC derivatives portfolios to central clearing.
Taking stock of the efforts made, giving due consideration to the work and discussions of
the Expert Group of the Commission and taking into account the responses to the public
consultation, ESMA has prepared this second report, in cooperation with the EBA, EIOPA
and ESRB.
As detailed in this second report, it seems very unlikely that after so many efforts from all
stakeholders and regulators since the start of the exemption, a new and never thought of
‘silver bullet’ solution emerges at this stage. This also means that the solution towards which
we are moving seems rather to be the optimisation by different actors (regulators, CCPs,
clearing members and their clients) of already existing solutions. Although some of these
existing solutions need to be further developed or might need regulatory consideration, their
addition should provide the conditions for PSAs to be able to clear and meet variation margin
calls in all states of the market that have been considered in the discussions.
ESMA is convinced of the benefits of a broad adoption of the clearing obligation, including
for PSAs, and would like to reiterate its view that exemptions, or extensions of exemptions,
from the clearing obligation should thus be carefully considered. However, the additional
efforts needed for implementing the solutions described in the report and ensuring readiness
may still require additional time.
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Contents
This report presents in Section 3 the regulatory context of this report, the next regulatory
steps initiated by EMIR Refit and what is their implication for ESMA. Section 4 provides
information on the participation to ESMA’s public consultation, while Section 5 describes the
role of derivatives as an integral part of PSAs’ investment approach. Section 6 deals with
central clearing requirements applied to PSAs’ derivatives portfolios and provides
quantitative data with respect to the typical structure of PSAs’ investment portfolio and the
estimated impacts of the clearing obligation for PSAs in terms of initial margin, cash
allocation and yield drag. Section 7 revisits the ongoing exemption of clearing for PSAs.
Section 8 presents the features of an overall solution as a combination of improved available
services, including what could be done by the industry or in terms of regulatory measures to
make these solutions more widely used. Section 9 provides elements on the Covid-19 crisis
and its impact on bilateral and cleared markets. Section 10 refers to the access to alternative
emergency liquidity arrangements. Section 11 provides the conclusion to this report. The
last section highlights the expected steps following this report. Annex 1 provides the EMIR
Refit articles relevant to the central clearing obligations for PSAs.
Next Steps
ESMA has now submitted this second report to the European Commission which would
serve as input to the European Commission’s own report.
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2 Introduction
1. EMIR requires specifically identified standardised OTC derivatives to be cleared via a
central counterparty (CCP) as a measure to mitigate risks. OTC derivatives are vital to
manage European pension funds’ solvency risks and ESMA is very much aware of the
challenges that PSAs would face to start clearing their OTC derivative contracts.
2. It must be highlighted that the occupational pension funds’ landscape is very
heterogeneous across EU countries, not only in terms of size, but also in terms of
vehicles or nature of the pension objective1. Some Member States mostly rely on the
pay-as-you-go first (public) pillar to provide for adequate pensions, while in others there
is a more substantial role of the second (occupational pensions) and third pillars
(personal pensions). EU countries representing a significant share of pension fund
assets in the EU are the Netherlands, Denmark and to a lesser extent Ireland 2 .
Moreover, it is in these two first jurisdictions that the use of derivatives by PSAs is the
most pronounced.
3. Central counterparties currently only permit variation margin (VM) to be posted in cash.
Holding cash buffers results in heightened liquidity requirements and could have knock-
on effects on the strategic investment allocation for PSAs, which in turn was identified
as an obstacle for them to access central clearing. In other words, and broadly
speaking, some PSAs might need to disinvest, and thus risk lower returns for their
pension funds, hence lower retirement incomes, in order to meet cash VM calls,
whereas they would have non-cash collateral available otherwise.
4. EMIR introduced to this end an initial temporary exemption, which expired on 16 August
20183, for PSAs from the clearing obligation to allow time for a suitable solution for the
transfer of non-cash collateral as VM to be developed.
5. In view of the fact that no suitable technical solution for the transfer of non-cash
collateral as VM had been found by CCPs, clearing members and PSAs, the co-
legislators agreed to amend EMIR (EMIR Refit) and included amongst other measures
a further extension until June 2021, potentially to be extended by another year or two,
of the temporary exemption for PSAs from the clearing obligation.
6. There are a number of reasons which, so far, may have prevented viable solutions to
be developed. Firstly, this includes the characteristics of some PSAs’ derivative
portfolios, which are typically significant, long dated and unidirectional, coupled with
investment strategies that usually prevent PSAs from increasing their cash holdings
and a limited access of PSAs to liquidity via banks. Secondly, there have been risk
management considerations of a technical and legal nature or with respect to liquidity,
1 It must be highlighted that Pension Scheme Arrangements are not only pension funds (i.e. Institutions for Occupational Retirement), but also include other national arrangements with the objective of asset management for retirement purposes. 2 The United Kingdom was also in that list at the time of the entry into force of EMIR Refit, before its subsequent withdrawal from the EU. 3 The initial temporary exemption was in fact extended in order to be valid until August 2018.
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introducing significant complexities for CCPs to step away from their current cash VM
protocols. Viable solutions have therefore required significant efforts and collaboration
from a number of actors from the industry, and an open dialogue with policymakers,
regulators and central banks.
7. Based on the varied input received through the consultation and from the Commission’s
Expert Group discussions, it is ESMA’s understanding that a large majority of
stakeholders is looking forward to a situation where PSAs would be able to clear more
widely and that a majority of PSAs do want to clear. It is indeed only a matter of time
before PSAs will need to clear their derivatives trades, not only because the exemption
will eventually expire, but also because it provides very valuable safeguards and
because a large portion of the liquidity is expected to shift to central clearing due to
strong incentives provided by market and regulatory forces, driven in part by clearing
obligations, bilateral margining requirements or capital requirements. Hence, there is
urgency and eagerness to develop one or several viable technical solutions.
8. Moreover, with respect to systemic risk, the April 2017 ESRB opinion on the Revision
of the European Market Infrastructure Regulation concluded the below, which ESMA is
in full agreement with:
“While recognising the challenges faced by some counterparties in meeting the clearing
obligation, the ESRB advises caution regarding exemptions from central clearing. It
agrees with the European Commission’s assessment that disproportionate costs and
burdens need to be reduced. However, it supports a broad application of the clearing
obligation, including for pension scheme arrangements and large non-financial
counterparties (NFCs) that are active in the derivatives market.”
9. The European Commission has set up a dedicated stakeholder group which brings
together pension funds, CCPs, banks, CSDs, EU policymakers and central banks in
order to work on a robust solution to the cash VM issue that can be relied upon in
stressed market conditions.
10. ESMA’s first report was published in April 2020 and initiated a public consultation in
order to collect views from stakeholders beyond those of the Expert Group created by
the European Commission, such as potentially smaller PSAs, as well as to collect
updated data on European PSAs’ portfolios and on the quantitative impact of moving
their OTC derivatives portfolios to central clearing. The results of this public
consultation are an integral part of this report. It must also be noted that, in light of
Brexit, the report focuses on EU27 jurisdictions, for PSAs as for CCPs, and that a sub-
section is dedicated to the impact of the Covid 19 crisis on the relevant financial
markets.
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3 Regulatory context of this report
11. EMIR Refit (see Annex 1) provides that the Commission should monitor the progress
made by CCPs, clearing members and PSAs towards viable solutions facilitating the
participation of PSAs in central clearing and prepare a yearly report on that progress.
12. In order to provide input for this report from the European Commission, ESMA is
required to produce a first report within 6 months from the entry into force of Refit, and
every 12 months thereafter until the end of the exemption period, in cooperation with
the EBA, EIOPA and the ESRB. A first report was provided to the European
Commission in April 2020 and also served as a basis for a public consultation, in order
for ESMA to collect feedback, input and views from stakeholders beyond those of the
Expert Group created by the European Commission, such as potentially smaller PSAs,
as well as updated data on European PSAs’ portfolios and on the quantitative impact
of moving their OTC derivatives portfolios to central clearing and use them for a more
comprehensive second report.
13. The first report of the European Commission under Article 85(2) of EMIR assessing
whether viable technical solutions have been developed for the transfer by pension
scheme arrangements of cash and non-cash collateral as variation margins and the
need for any measures to facilitate those viable technical solutions has been published
on 23 September 2020.
14. These reports must not only cover the solutions themselves but also the related costs
for PSAs, thereby considering regulatory and market developments such as changes
to the type of financial counterparty subject to the clearing obligation, and specifically
must assess:
• whether the main market stakeholders have reached viable technical solutions to
facilitate the participation of PSAs in central clearing by posting cash and non-cash
collateral as VM;
• the implications of those solutions on market liquidity and procyclicality and their
potential legal implications;
• the volume and nature of the activity of PSAs in cleared and non-cleared OTC
derivatives markets, within each asset class, and any related systemic risk to the
financial system;
• the consequences of PSAs fulfilling the clearing requirement on their investment
strategies, including any shift in their cash and non-cash asset allocation;
• the implications of the clearing thresholds for PSAs;
• the impact of other legal requirements on the cost differentials between cleared and
non-cleared OTC derivative contracts, including margin requirements for non-
cleared derivatives and the calculation of the leverage ratio;
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• whether any further measures are necessary to facilitate a clearing solution for
pension scheme arrangements.
4 Public consultation
4.1 Presentation
15. It was ESMA’s conviction that a public consultation with all stakeholders was necessary
to further inform the assessment of potential solutions, with the input from a wide range
of stakeholders. Consequently, ESMA took advantage of the publication of the first
report to also consult stakeholders. This consultation has allowed ESMA to gather input
and drill further down into the issues, collect useful data and get a better representation
of the range of views from stakeholders beyond the ones actively participating in the
Expert Group.
16. The feedback received from the consultation, along with the additional discussions of
the Expert Group have served as the basis for developing this second report due as
per EMIR Refit by December 2020.
4.2 Participation
17. ESMA received in response to the public consultation 19 individual or trade association
responses, including 2 confidential ones, and 1 joint response from 10 stakeholders
from the pension fund industry.
18. More specifically, responses were provided by 8 market associations, 6 asset
managers which count pension funds as key clients, 2 pension providers, 2 central
counterparties, 1 bank, 1 federation of pension funds as well as 1 Central Bank.
19. Responses were received from stakeholders from the Netherlands, Germany, Sweden,
the United Kingdom, Denmark and Ireland. A large share of the quantitative data was
provided by Dutch stakeholders, hence a possible over-representation of Dutch PSAs
compared to other European ones, i.e. primarily Danish or Irish PSAs, in the report. We
however believe that Dutch PSAs constitute a good proxy for the EU pension fund
sector as at the end of March 2020, our figures indicate that they were accounting for
70-80% of the notional amount of derivatives of all EU pension funds.
20. The large spectrum of stakeholders who replied to this consultation has allowed to get
diverse views on all parts of the envisaged solutions.
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5 Derivatives as an integral part of PSAs’ investment
approach
21. With an estimated total of aggregated assets above 2.7 trillion euros in the European
Economic Area (EEA) at end 2019 (excluding UK)4, the European pension fund sector
is a major participant in derivative markets.
22. The significance and size in terms of assets under management of private pension
funds is diverse in the EEA. It is dominated by the large Dutch pension fund sector with
investment assets amounting to 1.3 trillion euros at end 20195. As for Denmark, its
pension fund market was estimated at 595 billion euro at end 20186. With regards to
the average ratio of assets to GDP, as of end 2018, Denmark topped the ranking with
assets worth 198.6% of GDP, followed by the Netherlands with 173.3%.
23. Unlike US peers, which use predominantly corporate bonds, many PSAs concentrated
in some EEA countries use OTC derivatives as an integral part of their investment
approach in order to manage their financial solvency risk, which also allows them to
comply with the prudent person principle. The reasons for PSAs to use derivatives are
an interplay of several considerations.
24. Structurally speaking, the liabilities of EEA PSAs are long dated: 50 years and longer
with an average maturity at around 25-30 years (longer than US pension funds for
instance), one-directional and linked to interest rates and/or inflation. To hedge their
liability risks, PSAs typically invest in high-quality government bonds.
25. The most commonly mentioned reason for the use of OTC derivatives by PSAs is the
insufficient number of issuances of long dated high-quality bonds restricting the ability
of EU pension schemes to manage the interest rate risks adequately. As confirmed in
the responses to the public consultation, the EU bond landscape, both sovereign and
corporate, lacks scale and availability in several key sectors. Examples provided refer
to the lack of AAA-rated sovereign bonds with a maturity greater than 30 years and the
lack of long duration AA-rated corporate bonds eligible for determining IAS19-based
liability discount curves. The inadequacy between long duration segments and long-
dated liabilities leads to a trade-off between credit quality, liquidity, and capital
efficiency.
26. Figure 1 provides an illustration of the liability profile for an Irish pension fund whose
liabilities extend approximately to 50 years, while in comparison Figure 2 highlights the
swift decrease in the availability of EU investment grade (IG) government and corporate
bonds from circa 10 years of maturity.
4 PensionEurope, Pension Fund Statistics 2019 5 Table 1.19 of statistical tables from OECD report 'Pensions Markets in Focus 2019' (http://www.oecd.org/daf/fin/private-pensions/globalpensionstatistics.htm) 6 https://www.forsikringogpension.dk/media/4693/pension-assets-held-by-institutional-investors-dkkbn.pdf
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Figure 17: Illustration of liability profile for an Irish pension fund
Figure 28: EU investment grade (IG) government and corporate bonds maturity profile
27. Although this trade-off could be alleviated by increasing the amount of long-dated
issuances, the use of derivatives versus bonds goes beyond closing the duration gap.
Other aspects have an impact on PSAs’ decisions to use derivatives, such as the
objectives of the PSA, considerations on spread risk, needs of higher returns or intrinsic
characteristics of derivatives.
28. Some PSAs can indeed have certain objectives requiring them to hedge a significant
amount while at the same time match some expected returns or inflation-linked targets.
7 Source: response to ESMA’s public consultation 8 Source: response to ESMA’s public consultation
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For instance, it was highlighted during the consultation that many PSAs have objectives
other than nominal matching. Given that these different objectives, to be fulfilled, will
require different financial instruments (such as sovereign and corporate bonds, private
credit and other illiquid investments), a Liability Driven Investment (LDI) strategy is
often chosen to manage the interest rate exposure while taking other investments’ risk
exposures into account. In such cases the recourse to interest rate swaps helps
optimise efficiency.
29. Secondly, in certain EU jurisdictions, the swap curve is the regulatory discount curve,
meaning that it makes sense to hedge those liabilities using swaps rather than any
other instrument. In the Netherlands for instance, where the assets under management
held by PSAs are the largest in the EU, liabilities are discounted using market swap
rates for the first 20 years. Thereafter, Dutch pension funds increasingly use a historical
ultimate forward rate, which is lower than the ultimate forward rate used in the EIOPA
swap curve. In Denmark, pension fund liabilities are discounted using the EIOPA swap
curve, while in Ireland pension fund liabilities are also increasingly discounted using
swaps. In a nominal regulatory framework with the euro swap curve as the discounting
curve, hedging liabilities with any other instrument than euro swaps would thus create
a spread risk. Limitations on how much spread risk a PSA is allowed to take, associated
to the fact that many sovereign and corporate bonds have poor hedging quality as their
correlation with the swap curve is too low, imply that euro swaps are the best hedging
instrument by nature, most especially in stressed markets where the need for perfect
hedges is most prominent.
30. PSAs collect pension premia, invest these in assets with certain risk premia such as
equities or real estate, and share the investment risk collectively. Thus, another reason
for PSAs to use derivatives relates to their need to invest a sizeable part of their
portfolios in assets with a higher expected return such as equities. Should a PSA build
an investment portfolio fully matching its liabilities, there would be insufficient money
left to invest in assets with higher returns and these insufficient investment returns
would impact future retirement incomes.
31. Lastly, OTC derivatives can be tailored to exactly match the dates of PSAs’ liabilities,
allowing a more accurate cash flow matching than with bonds.
32. The public consultation accompanying ESMA’s first Report published in April 2020
allowed to collect, as was one of its goal, quantitative data with respect to the structure
of PSAs’ portfolios, and in particular regarding the duration gap which derivative
strategies are designed to address.
33. Looking at Member State level, in the Netherlands, according to the Netherlands Bank
(‘DNB’) statistics at Q4 2019, the average hedge ratio for a Dutch pension fund is 49%.
Even if the breakdown between fixed income instruments and derivatives will differ
across pension funds, out of these 49% of hedge, the fixed income portfolio contributes
of up to 10-25% in average, leaving 25% to 40% hedged with derivatives. Therefore,
more than half of the interest rate hedge is achieved through derivatives.
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34. At a more granular level (Dutch asset managers and pension funds 9 ), the trend
observed at national level is corroborated.
Table 1: Asset Manager 1 - Average for pension fund clients10
Average duration of liabilities 25 years
Interest Rate Risk Hedge Ratio 58%
Hedge via Fixed Income Assets 30%
Average duration of these Fixed Income Assets 8 years
Hedge via Interest Rate Derivatives 28%
Duration gap 17 years
35. It also proves insightful to look at the impact of a 1bp change in the curve (also known
as “DV01”), clearly showing that the biggest part of the interest rate hedge needs to
come from derivatives such as interest rate swaps.
Table 2: DV01 of the gap to be hedged with OTC derivatives for baskets of Dutch PSAs11
DV01 (in mEUR) / Baskets of Pension Fund Clients12 Basket 1 Basket 2 Basket 3
Liabilities 253 35 10
Liabilities to hedge 143 19 6
IR Risk Hedge Ratio 57% 54% 63%
Hedge via FI assets 36 6 1
Share of FI assets in total hedge 25% 31% 15%
Gap to be hedged with derivatives 107 13 5
36. All these factors lead to the fact that, unlike US pension funds, in a few Member States
an integral part of the investment approach of a substantial proportion of the European
pension fund sector (in terms of assets), yet limited to relatively few actors, is to use
9 Data anonymised as submitted as confidential to ESMA 10 Source: response to ESMA’s public consultation 11 Source: response to ESMA’s public consultation 12 This table shows the impacts in million EUR of a 1 bp change in the rate curve: on the second row the impact from the total liabilities to hedge, on the fourth row the contribution in dv01 terms of the different fixed income portfolios and on the last row the resulting DV01 gap which needs to be filled with derivatives
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OTC derivatives to manage their interest rate risk as their liabilities are often long-
dated, unidirectional and linked to interest rates and/or inflation. Pension funds are
allowed to use these derivatives only for managing risks13.
37. Consequently, such European PSAs typically have derivative portfolios which are
large, long-dated and unidirectional to offset risk relating to their liability profiles.
38. On the one hand, derivatives portfolios with such characteristics of size, duration and
directionality amount to a sizable level of counterparty risk, and, considered from the
angle of the aggregate position of the industry, potentially even of systemic risk. This
has precisely been the type of risk that led to the introduction of the clearing obligation
in the first place.
39. But on the other hand, an array of factors mitigate the systemic nature of this risk:
a) Derivatives portfolios of PSAs are held to reflect and offset their liabilities, generally
leading to a risk-neutral position overall.
b) PSAs are subject to stringent prudential supervision14 requiring them to be able to
withstand extreme shocks to the value of their assets and liabilities and still be able
to meet their financial obligations. In addition, national regulations aim at ensuring
the highest possible level of protection for policyholders and beneficiaries.
c) They are asset-rich long-term investors holding a significant proportion of high-
quality government bonds.
d) PSAs can rely on different recovery mechanisms such as benefit cuts, increased
premiums or sponsor support, to restore funding levels in the case of underfunding.
e) In certain EU jurisdictions, quasi-governmental organisations or protection funds
are established to ensure that the assets and liabilities of pension funds are
protected in the event of default of the corporate sponsor.
f) Such characteristics tend to magnify the implications of OTC derivatives
regulations for pension funds, in particular the magnitude of initial margin required
due to their long-term unidirectional cleared portfolios.
40. In conclusion, PSAs may have a structural need for engaging in OTC derivatives and
specifically in standardised OTC derivatives, which are also the ones mandated to be
cleared. Even if a larger availability of long-dated bonds, both from sovereign and
corporate issuers, would likely mitigate the potential need for long-dated derivatives,
the other considerations mentioned earlier would still likely result in the potential need
to use derivatives to most efficiently align the portfolio to the strategic objectives of
PSAs. The use of derivatives by PSAs are however impacted by bank capital rules on
13 Article 18.1(d) of the IORP Directive (2003/41/EC) stipulates that “investment in derivative instruments shall be possible insofar as they contribute to a reduction of investment risks or facilitate efficient portfolio management”. This requirement is carried over into the IORP II Directive, which applies from January 2019. 14 Via the two frameworks IORP II and Solvency II, which however do not include explicit liquidity requirements
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non-cleared trades, the posting of cash VM in both cleared and non-cleared markets
and other challenges related to clearing.
6 Central clearing requirement applied to PSAs’ derivatives
portfolios
6.1 Benefits and Reasons to clear
41. A very large majority of respondents to the public consultation are supportive of central
clearing and expressed their strong interest in central clearing solutions. Most have
highlighted that the benefits of central clearing outweigh the significant operational
costs incurred by market participants and end-investors to comply with clearing
mandates. There are indeed many drivers as to why PSAs voluntarily choose to clear
today: increasing liquidity in cleared products, counterparty credit risk reduction and
trading efficiency, economics of the trade and cost advantages and netting margin
efficiencies.
42. Enough liquidity in a cleared product is one of the most important factors driving end-
investors’ willingness to voluntarily clear derivatives. A moderate increase in liqu idity
increases the likelihood of voluntary clearing.
43. Access to a broader set of liquidity providers aids best execution and improves the
likelihood and efficiency of execution. Compared to the bilateral market where an end-
investor must assess the creditworthiness of its counterparty as well as other factors
such as the execution price, the executing broker for a cleared trade presents minimal
credit risk, which opens up a larger universe of dealers.
44. The cleared price across asset classes is in general cheaper at execution. Though this
can vary depending on the specific trade and executing broker, it is likely to be one of
the main factors behind greater adoption of voluntary clearing going forward.
45. Netting margin efficiencies for end-users are another potential significant and positive
cost advantage. Against arguments related to its embedded cost, clearing has the
significant advantage of reducing collateral requirements in case of a non-directional
position in derivatives. A long and short contract with exact same details will show near
zero required initial margin, while traded bilaterally with two different counterparties
they will lead to double collateral requirements.
46. In addition to the above recognised benefits of reduction in bilateral counterparty credit
risk, respondents argue that central clearing also ensures proper collateralization of
risks, facilitates the standardization of contracts/instruments, provides regulators with
transparent reporting and decreases the likelihood of public bail outs in case of defaults.
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47. A concrete illustration of the benefits of standardization can be observed in the
Eonia/€STR transition. While for cleared trades the process is transparent, for bilateral
derivatives this switch of index requires some negotiations between the two parties.
6.2 Access to clearing
48. PSAs are currently using clearing members to access CCPs for many reasons that go
beyond the posting of cash margins, and, based on the responses to the consultation,
it sounds unlikely that they would become direct clearing members of CCPs at this
juncture to clear swaps.
49. Indeed, clearing members provide their clients, including PSAs, with a wide suite of
ancillary services on top of the core clearing services15, including the funding of cash
margins and collateral transformation services. In addition, clearing members also
provide vital operational support in terms of technology to manage messaging systems
and protocols, collateral, treasury planning and margin calls. These ancillary services
are a vital component of the clearing service, as most PSAs do not have the technical
or operational capacity to replicate these functionalities and become direct members.
50. Some PSAs are currently direct clearing members to CCPs for repo and/or securities
lending clearing, unlike in OTC derivatives markets. Where PSAs do so, they typically
use the recently introduced sponsored clearing models (sometimes referred to as
hybrid clearing model16), as obligations for sponsored members have been adapted to
address the challenges that PSAs face regarding access to cash, where for instance
VM can be posted in securities after the IM and VM obligations have been netted down.
51. In a sponsored clearing model, the PSA needs to rely on the services of a broker/dealer
acting as ‘clearing agent’. Since under the sponsored clearing models a clearing agent
typically guarantees the (basic) clearing member’s performance (i.e. that of the PSA),
the contractual arrangements that PSAs have in place with clearing agents contain a
large number of substantially similar provisions to the contractual arrangement with a
clearing member in a traditional clearing model.
52. While a hybrid direct access clearing model via sponsored CM is available for repo
clearing for some large pension funds, it is not straightforward to copy that model
across for OTC derivatives clearing. In particular, given the short-term nature of repo
transactions, the arrangement is more sustainable than it is for OTC derivatives where
the duration is longer and VM calls can be quite substantial.
15 https://www.esrb.europa.eu/pub/pdf/reports/esrb.report_200109_mitigating_procyclicality_margins_haricuts~0f3e9f9e48.en.pdf 16 ESMA issued a Q&A on the implementation of EMIR with regards to sponsored models and the question of the EMIR definitions regarding clearing members and clients.
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6.3 Current & projected cleared volumes of PSAs
53. While some PSAs continue to take advantage of their exemption from the swaps
clearing obligation, some large PSAs are today voluntarily clearing what they can so
that they can reduce their uncleared derivatives exposures, bringing exposure below
the threshold in order to delay or avoid being brought into scope for the IM requirement.
Other smaller end-users which wouldn’t be caught by the IM rules today, are
nevertheless also voluntarily clearing in preparation. Where PSAs decide to voluntarily
clear, they do so primarily due to liquidity in cleared products, execution efficiency and
various cost considerations. This indicates that clearing mandates are not the only
drivers in having a broad adoption of central clearing and that these firms actually see
benefits in clearing.
54. Responses to the consultation have shown that while some Dutch asset managers
noted that their PSA clients clear on average 32% of their interest rate swaps portfolio
and even estimate that this share could easily increase to 50% or more if the
impediments to clearing were to be removed, others reported that only a very limited
share (1%) of their large PSA clients has been cleared to date, even though both their
interest rate swaps and inflation swaps portfolios are suited for clearing, most likely due
to the fact that for these specific clients impediments for clearing (including this cash
VM issue but not only) have not been removed yet.
55. The Netherlands Bank (DNB), based on reported data, provided some further
granularity with respect to the above clearing rates for Dutch PSAs. According to EMIR
reporting data, the clearing rates for Euribor and Libor IRS for the Dutch PSAs in Q3
2020 amounted to:
• for large pension funds: 22% on average (ranging from 3-26%)
• for middle-large pension funds: 25% on average (ranging from 0-46%)
• for small pension funds: 37% on average (range from 0-100%)
56. Furthermore, based on an analysis from the Danmarks Nationalbank, Danish PSAs are
also already using central clearing to some extent: overall, approximately 42% of their
interest rate derivatives are cleared by a CCP17, while this share varies considerably
across companies.
57. The perception across asset managers is that the bilateral interest rate swap market
will gradually move to central clearing given that uncleared margin rules incentivize
clearing and can make it more expensive for banks to trade uncleared.
17 Chart 4 of Danmarks Nationalbank’s analysis: https://www.nationalbanken.dk/en/publications/Documents/2019/11/ANALYSIS_No%2023_Pension%20companies%20will%20have%20large%20liquidity%20needs%20if%20interest%20rates%20rise.pdf
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58. Moreover, with respect to the range of products offered to be cleared by CCPs, it looks
like for most of the small and medium-sized Dutch PSAs, cleared derivatives would be
sufficiently available.
6.4 Impact on Portfolios allocations
59. Responses from the consultation revealed that it is not uncommon for pension funds
to have a cash allocation as low as 0%-3% and most of this will be cash held for the
purpose of paying out retirement income. In the Netherlands for instance, where most
pension funds are defined benefit pension funds, an asset allocation of zero cash is
typical18, while In Ireland, cash accounted for 3% of assets in 201819, and here as well
most of it is dedicated to pay out retirement income.
60. Due to new regulations, not only EMIR but also bank capital regulation, in recent years
the collateral obligations have had an increasing impact on the liquidity needs for PSAs,
not only in absolute terms due to higher collateral demands but also in the type of
collateral required. Certain Dutch asset managers confirmed that they already advise
their PSA clients to hold an immediately available cash buffer to protect against a
sudden rise of a few bps in interest rates.
61. The requirement for EU PSAs to clear all new interest rate swaps would be expected
to lead to a gradual shift of part of their available collateral from bond collateral to cash
collateral, as VM of cleared positions must be posted in cash. This would have negative
consequences on the expected return on their total portfolio as cash has a lower
expected return than other asset classes, and which will also expose PSAs to
concentrated credit risks to the banking sector, as opposed to sovereign or non-
financial corporate risk. And with regards to PSAs having long-dated liabilities, their
preference goes to investing in long-dated assets as well.
62. Moreover, as long-term investors, there is no need for PSAs to be very liquid as
incoming pension premia are generally larger than outgoing pension payments. Thus,
from an investment perspective, PSAs prefer to invest as much as possible in illiquid
assets with large liquidity premia.
63. However, the Dutch Fund and Asset Management Association (DUFAS) recognised
that the consequences of fulfilling the clearing VM cash requirements will differ between
PSAs as this depends on multiple factors, including the current investment strategy,
the hedge ratio of the PSA’s liabilities and the cash management policy, and highlighted
that an integrated cash management approach could limit the negative impact of
18 https://www.thinkingaheadinstitute.org/en/Library/Public/Research-and-Ideas/2020/01/Global-Pension-Asset-Study-2020 (page 16) 19 Defined Benefit schemes Review of 2018 statistics by the Pensions Authority: https://www.pensionsauthority.ie/en/news_press/news_press_archive/defined_benefit_schemes_-_review_of_2018_statistics.pdf
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additional cash holdings for small and medium-sized Dutch PSAs. To achieve this, cash
management should be part of the strategic asset allocation of PSAs. A clear cash
management with sufficient high buffers with the objective to fulfil cash requirements in
case of extreme market movements should be set up.
64. DUFAS further explained that the cash buffer depends on the interest rate sensitivity
of the swap portfolio, so that the cash buffer moves with the size of the swap portfolio.
Upper and lower limits for the cash buffer provide for a high degree of certainty that
collateral obligations can be fulfilled under normal circumstances and that the cash
buffer is not too large. Those limits can be based on the initial margin requirements and
on historical interest rate movements. Because future interest rate movements can vary
from historical ones, the minimum buffer should be efficient enough to deal with more
extreme market movements than historically seen. On the other hand, PSAs should
have a maximum buffer to ensure that cash positions won’t become too high.
65. DUFAS added in their response to the consultation that PSAs, by combining their cash
requirements from the VM OTC clearing requirements with the cash collateral
requirements of FX instruments, may lower the required cash buffers.
66. Asset managers who submitted a response to the consultation noted that, even if it
would be difficult to calculate what the investment portfolio would have looked like
without any liquidity constraints, it is fair to say that PSAs hold more liquid assets than
necessary from an asset and liability management perspective. The yield drag resulting
from this is also hard to quantify but is expected to be significant.
6.5 Other challenges
67. Cleared trades require VM calls to be settled on a same-day (T+0) basis, versus a T+1
basis for non-cleared trades. It has however been reported that clearing members may
apply more relaxed timeline for clients, so those may not necessarily pass through the
margin calls on a same-day basis.
68. Although posting cash VM remains the most significant issue for PSAs relating to
central clearing, clearing also results in other second-order risks that are not present in
the bilateral markets and that PSAs cannot mitigate by themselves as it would require
structural and industry changes.
69. Another consideration constraining the use of cleared derivatives comes from the
capital rules for banks. Some Dutch asset management firms described their
experience: the cost of clearing is relatively high because of the capital that clearing
members need to hold against client positions, even for PSAs and their high
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creditworthiness. These capital constraints 20 also make it more difficult to have a
broader number of clearing members and/or to get higher trading limits for PSAs.
70. The risk related to the clearing activity with one clearing member remains prominent
for large PSAs and can only be partially mitigated by selecting multiple clearing
members. In the event that one of their clearing members would fail, large PSAs still
fear that the chance of having their cleared portfolios successfully ported is small.
Should this not occur, a large part of their strategic hedge would be lost, with the
resulting financial losses. Besides a default, PSAs also fear the scenario where one of
their clearing members decides to stop providing such services. With often a 90-day
termination notice clause21 in their contracts, PSAs may run the risk to be unable to
hedge their positions.
71. Still with respect to clearing brokers offering clearing services for OTC swaps, their
concentration could increase the cost of interest rate hedging for clients and may lead
to concentration risk concerns, such as a limitation on the volume of derivatives clients
would be able to clear via each clearing member. This is particularly true for large
clients with directional positions such as PSAs, where their capacity to hedge with OTC
swaps could be impacted.
72. It must however be noted that this last issue is not specific to CCP cleared transactions
and exist as well in the bilateral world. For instance, operational and credit risk
considerations already limit the number of banks executing 30 or 40 year-long OTC
swaps with PSAs bilaterally.
73. PSAs also reported that, for cleared derivatives, concentration risk and capacity
constraints are important considerations and limitations. In the current clearing
environment running high concentration risks in a very limited number of CCPs is a
concern to them as the potential loss resulting from the default of a CCP would be very
significant. However, not only the risk of a CCP getting into default is very low but also
this consideration is common to all CCP’s participants.
74. Lastly, while the incentives to clear have successfully led to a gradual shift of the market
to cleared trades, respondents argue that the cost to the financial institutions (the
clearing members) providing access to clients has increased, coupled with significant
administrative and legal costs associated with setting up central clearing. They indicate
that the process of having to switch to central clearing can therefore be quite
burdensome, especially for small PSAs which have only a few derivatives in portfolio
(although the figures in paragraph 55 seem to indicate differently with larger clearing
rates for the smaller PSAs category, but in any case, this would need to be considered
at a more granular level). However an accurate assessment of the impact of central
clearing for PSAs should not look at the costs they would have to bear in isolation but
20 It should be noted though that CRR was amended in 2019, including with respect to the Leverage Ratio Framework in order to align the incentives for a broad clearing obligation, as is explained in Section 8 of the report. 21 ESMA submitted technical advice to the Commission on the FRANDT principles as input for the related Delegated Act that is under the responsibility of the Commission.
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should equally take into account the costs for pensioners resulting from failed risk
management and potential defaults of PSA trading counterparts.
6.6 Estimated impact
6.6.1 In terms of baseline Initial Margin and possible add-ons
75. The 2018 study by ISDA and Pension Europe on the “Potential demand for clearing by
EU Pension Funds”22 estimated that a clearing mandate capturing Dutch and Danish
pension funds (excluding UK funds) would increase cleared IM by approximately
€7.4bn if only new trades had to be cleared, by €26bn if 50% of the back-book were to
be cleared, and by €44bn if 100% of the back-book were to be cleared.
76. Moreover, a large Dutch PSA with a one-directional swap position could typically be
assessed as a large risk contributor by CCPs. One of them provided ESMA with an
estimate that its additional liquidity add-ons on IM could quickly be as large as 2 to 3
times its standard IM, so significant that they could cause the PSA to consider the
implementation of a ceiling on the number of swaps it would be able to clear.
6.6.2 In terms of cash holdings
77. From the responses to the consultation, in the Netherlands, some asset managers
estimate that their pension fund clients hold on average approximately 2% in cash so
that they can withstand a sudden increase in interest rates. If all interest rate swaps
would be cleared, this would need to be increased to approximately 6%.
78. For some others, however, the strategic allocation to cash is zero so it is safe to assume
that they will not hold any large structural or permanent cash positions, other than a
limited amount of ‘friction’ cash. The below table presents, for a given confidence
interval of expected shortfall and a given share of liquid assets available on a one-day
horizon, the allocation of assets to a cash portfolio. This means that if the PSA wants
to be able to meet the VM calls estimated on the basis of the expected shortfall
calculations with a confidence interval of 99.8% and assumes that 30% of its cash
allocation is available on a one-day horizon23, it needs to allocate 7.8% of its assets to
a cash portfolio.
22https://www.pensionseurope.eu/system/files/Joint%20Paper%20ISDA%20and%20PensionsEurope%20paper%20on%20pension%20fund%20clearing%20demand_0.pdf 23 In the absence of any guaranteed collateral transformation mechanism, not all HQLA on the balance sheet can be used to meet the estimated cash outflow. Not all assets of this portfolio could be liquidated on a one-day horizon. If money market funds provide an example, a conservative estimate could be in the range of 10-30%. So the total size of the cash portfolio needs to be (at most) tenfold the estimated outflow.
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Table 3: Cash allocation for a given confidence interval of meeting VM call and a given
share of assets available daily24
Expected Shortfall
(%Confidence)
/ Daily available
10% 20% 30% 40% 50% 100%
99.95% 32.8% 16.4% 10.9% 8.2% 6.6% 3.3%
99.90% 27.6% 13.8% 9.2% 6.9% 5.5% 2.8%
99.80% 23.4% 11.7% 7.8% 5.9% 4.7% 2.3%
99.70% 21.1% 10.5% 7% 5.3% 4.2% 2.1%
99.50% 18.6% 9.3% 6.2% 4.6% 3.7% 1.9%
99.00% 16% 8% 5.3% 4% 3.2% 1.6%
98.00% 13.4% 6.7% 4.5% 3.3% 2.7% 1.34%
6.6.3 In terms of yield drag
79. The OECD pointed out in its annual pension report statistics25 that the Dutch pension
sector had an annual average return over the past 15 years of around 6.1%. An extra
allocation to cash of 5%-10% would mean a drag on annual returns of around 0.3%-
0.6%, assuming the return on cash is negligible. With assets of around €1.55 trillion as
of end 2019, this would imply a negative impact of €4.7 billion to €9.4 billion in expected
returns for the Dutch pension sector.
Table 4: Potential drag on PSAs returns for a given allocation to cash for the Dutch PSA
sector (for AUM of €1.55 trillion as of end 2019)26
Cash holding Reduction in annual return
in %
Reduction in annual return
in € billions
5% 0.3% 4.7
10% 0.6% 9.4
15% 0.9% 14.1
20% 1.2% 18.8
24 Source: response to ESMA’s public consultation 25 http://www.oecd.org/finance/private-pensions/survey-large-pension-funds.htm & http://www.oecd.org/daf/fin/private-pensions/globalpensionstatistics.htm 26 Source: response to ESMA’s public consultation
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80. Contributions from Dutch asset managers counting PSAs as their key clients however
reflect a very diverse reality with regard to current cash buffer levels and yield drag.
81. As shown above at national level, some asset managers calculated the difference in
expected return should a PSA have to allocate 5% or 10% of its current investment
portfolio to cash and this allocation is pro-rata funded by all other asset classes. Given
that both the current economic environment expected returns and risk premia were
lower than normal at the time of the consultation, the estimated yield drag is on the
lower end of what this would be in longer term perspective.
Table 5: Illustration of the potential drag on a PSA’s returns for a given allocation to cash27
Allocation of portfolio to cash Expected average return per annum (yield drag)
Compared to the current annual return of 3.17%
+5% 3.00% (-0.17)
+10% 2.84% (-0.33)
Compared to a normal annual return of 6%
+5% 5.70% (-0.30)
+10% 5.40% (-0.60)
82. Some others reported that their PSA clients already hold a sizeable cash buffer and
therefore the costs of funding temporary high liquidity demands would be very low. It
would moreover be possible to construct their total portfolio in such a way that the
impact on the total risk and return parameters is minimal, especially when the required
cash buffer is only a few percentage points of the total portfolio.
6.7 Increased Liquidity Risk in stressed conditions
83. The primary concern of PSAs being subject to mandatory clearing is the availability of
liquidity in tail risk scenarios of extreme rates moves. Their main concern is the ability
to achieve certainty of access to liquidity to pay cash VM and in particular connected
to the reputational as well as commercial impacts of a potential technical default on
margin calls28. Indeed, PSAs typically minimise their allocation to cash in order to
maximise efficiency and increase the certainty of being able to afford their obligations
27 Source: response to ESMA’s public consultation 28 Such default would be declared by the clearing member of the PSA, as part of the client-clearing member relationship. Indeed CCPs have a direct relationship with clearing members, who bear the contractual financial obligation vis-à-vis CCPs.
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to policyholders. Requiring pension funds to clear OTC derivative contracts centrally
could lead them to either disinvest a significant proportion of their assets for cash or
face the risk of forced selling in stressed market conditions, in order to meet the cash
VM requirements.
84. Following the implementation of regulatory reforms, some respondents argue that the
shift to requiring counterparties, including pension funds, to post cash variation margin
(VM) in a short timeframe, introduces the potential for increased liquidity risk, as a by-
product of other objectives being sought out.
85. As all market participants, not pension funds only, will move to meet VM calls in cash,
the demand for cash is likely to increase in stressed conditions, when VM calls are
expected to be at their largest due to increased market volatility. PSAs fear that this
could in turn result in the forced sale of physical assets (even high-quality liquid assets)
to meet liquidity needs and exacerbate downward pressure on falling asset prices. In
the worst scenarios, this may ultimately increase procyclicality and systemic risks and
reduce financial stability.
86. It should be noted that some authorities have indicated that there would be room for
individual PSAs to get better prepared for the use of market-based solutions in order
to be able to meet significant VM calls in stressed market times. Enhancements to
PSAs’ liquidity management could, for instance, include the establishment of
prearranged and highly reliable funding arrangements with multiple liquidity providers
to convert assets into cash under stressed market conditions. This would increase the
resilience of individual PSAs to funding variations during stressed periods. For
instance, the ESRB flagged in recent reports 29 and publications 30 that liquidity
requirements in the Solvency II framework should be strengthened and that similar
considerations would also apply to IORP II.
6.7.1 Estimated impact of a 1% shift31 in rates to VM across EU PSAs
87. In terms of quantitative impact, assuming an average liability duration of 20 years and
a full (100%) hedge of its liabilities with derivatives, a PSA would see, for a
(conservative) 1% rate move, the mark-to-market move by circa 20% of notional
exposure of swaps and would need to source cash equal to 20% of its assets if it is
fully funded (assets equal to the present value of liabilities), or 28%32 if it has a funding
level of 70% (if assets are 70% of the present value of liabilities). Where liabilities are
hedged with swaps only up to 50%, the cash to be sourced will amount to 10% of assets
29 ESRB Report of February 2020 on Enhancing the macroprudential dimension of Solvency II - Section 2. Liquidity tools addressing risks arising on the assets and liabilities side (https://www.esrb.europa.eu/pub/pdf/reports/esrb.200226_enhancingmacroprudentialdimensionsolvency2~1264e30795.en.pdf) 30 ESRB response to the EIOPA Consultation Paper on the 2020 review of Solvency II, and https://www.esrb.europa.eu/pub/pdf/other/esrb.letter201016_on_response_to_Solvency_II_review_consultation~8898c97469.en.pdf 31 While the size of the shock may be extreme, it is commonly used as a baseline stress scenario by the industry. 32 70% of 20%
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if the fund's funding level is 100%, or 14% of assets if the funding level is established
at 70%.
88. Data provided in response to the consultation highlights that a 100bp (or 1%) parallel
shift in the yield curve would cause a cash VM requirement of circa €95bn across
Dutch, Danish and Irish PSAs using swaps (see Table 6). This is not far from the results
of the Europe Economics and Bourse Consult report estimate of approximately €105
to €130billion of potential cash collateral needed for EU27 pension funds.
Table 6: Estimated impact of a shift in rates on VM calls across EU PSAs33
Netherlands Denmark Ireland TOTAL
Total liabilities (EUR bn) 1,29134 59535 9136 1,988
Percentage of liabilities hedged37 40% 40% 25% N/A
Percentage use of swaps (for liability
hedging)38
63% 50% 65% N/A
Swaps notional (EUR bn) 323 119 15 457
Average duration (years)39 21 20 20 N/A
PV01 (EUR million)40 678 238 29
Potential VM call for 100 bps rate move (EUR
bn)
67.8 23.8 2.9 94.5
89. The European Central Bank also published in May 2020 a study on ‘Derivatives-related
liquidity risk facing investment funds’41, including a box on ‘Liquidity stress simulations
of euro area pension funds’ interest rate swap portfolios. While the estimated
magnitude of potential VM calls following a 100bps shift in the yield curve is revised
downwards for Dutch PSAs, from €67.8 bn above to a range of €36 - 47 bn, the impact
33 Source: response to ESMA’s public consultation 34 Table 1.19 of statistical tables from OECD report 'Pensions Markets in Focus 2019' (http://www.oecd.org/daf/fin/private-pensions/globalpensionstatistics.htm) 35 https://www.forsikringogpension.dk/media/4693/pension-assets-held-by-institutional-investors-dkkbn.pdf 36 IAPF Pensions Investment Survey 2018 https://www.iapf.ie/publications/surveys/annualinvestmentsurvey/ Defined benefit schemes: Review of 2018 statistics by The Pensions Authority https://www.pensionsauthority.ie/en/news_press/news_press_archive/defined_benefit_schemes_-_review_of_2018_statistics.pdf 37 Industry estimates 38 Industry estimates 39 Industry estimates 40 Estimate of the mark-to-market move (or potential VM call) for a 0.01% rate move = “Total liabilities x Percentage of liabilities hedged x Percentage use of swaps x Average duration / 10,000 41 https://www.ecb.europa.eu/pub/financial-stability/fsr/special/html/ecb.fsrart202005_02~d48451c1cb.en.html#toc6
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remains sizeable and would result in an aggregate cash shortfall of €6 billion to €15
billion across Dutch PSAs.
90. The ECB analysis also raises an issue linked to the concentration of this shortfall across
Dutch PSAs. Under the most pessimistic scenario (cash shortfall worth €15 billion),
circa 55% of Dutch PSAs would not have sufficient cash to cover their VM calls. The
cash shortfalls would be concentrated within a small number of pension funds with
relatively low VM payments: 61% of the overall cash shortfall would be attributed to ten
pension funds only, for a share in VM payments of 32%.
7 Exemption from clearing for PSAs
91. The 2008 financial crisis has underlined the importance of central clearing as an
effective risk mitigation tool. Central clearing has an important role to play in reducing
systemic risk in the OTC derivatives markets and remains a cornerstone of safe and
transparent markets. All respondents to this consultation have confirmed that they
fundamentally support central clearing. A majority of financial institutions are now
centrally clearing significant shares of their OTC derivative transaction portfolios,
thereby reducing systemic risk in line with the G20 commitments.
92. At the same time, the ongoing exemption from the clearing obligation for PSAs means
that PSAs continue to be exposed to the risks of under-collateralization and potential
defaults of large and systemic trading counterparties. This is particularly true in light of
the recent extensions of the phase-in for initial margin requirements.
93. Taking into consideration the long-term nature of the PSAs' activities and the structural
difficulties they face in meeting largely one-sided variation margin cash calls for the
clearing of their OTC derivatives through CCPs, EU policymakers provided a temporary
exemption from the requirement to centrally clear derivatives for PSAs within the initial
EMIR framework42.
94. The transitional provision also aimed at providing further time to find an alternative
solution which would allow pension funds to use their high-quality securities, to
ultimately meet their VM obligations for cleared derivatives. As of today, VM calls for
cleared derivatives must be fulfilled exclusively in cash for three main reasons: the
need for valuation certainty on the long maturities of many swap transactions; the fact
that swap portfolios typically contain trades in multiple currencies; and the fact that the
pass-through of VM is a critical component of financial stability given potential long-
term price fluctuations.
42 In terms of the exemption from the clearing obligation for PSAs, Capital Requirements Regulation envisages a similar exemption for banks’ capital requirements for CVA risk on trades entered with PSAs. Such exemption is specified under Article 382(4)(c) of the CRR, and is closely linked to the clearing obligation under EMIR, also in terms of timing for its application/expiry.
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95. More specifically, Recital 26 and Article 85(2) of EMIR establish that the clearing
obligation is not to apply to PSAs until an appropriate technical solution is developed
by CCPs for the transfer of non-cash collateral as variation margins.
96. This initial temporary exemption under EMIR for European pension funds expired on
16 August 2018. With the objective to avoid a disruption to certain PSAs who may have
faced potential challenges clearing their OTC derivative contracts between 17 August
2018 and the entry into force of the new temporary exemption under EMIR Refit, ESMA
publicly communicated that it expected national competent authorities to not prioritise
their supervisory actions towards entities that were expected to be exempted again in
a relatively short period of time, and to generally apply their risk-based supervisory
powers in their day-to-day enforcement of applicable legislation in a proportionate
manner.
97. It is within this context that the European Commission organized a series of roundtables
in 2017 and 2018 to facilitate the discussion between the relevant stakeholders,
including not only representatives of the PSAs and CCPs but also representatives from
the clearing members and from the Central Banks, to monitor progress of industry
efforts in this regard and to explore the remaining obstacles to the deployment of central
clearing solutions for PSAs.
98. As part of the EMIR review, the Commission recognised in its May 2017 legislative
proposal (also known as the EMIR Refit legislative proposal), that no viable solution
facilitating PSAs to centrally clear their OTC trades had been developed so far and that
the temporary derogation should therefore be extended further. The purpose of this
extension is to allow CCPs and other relevant stakeholders to develop a robust solution
to enable PSAs to centrally clear – including in periods of market stress – without
negatively impacting the revenues of future pensioners.
99. Following the entry into force of the amendments contained in EMIR Refit, EMIR now
states that the transitional provision for European pension funds will expire on 18 June
2021, and further specifies that the Commission may adopt a delegated act to extend
this exemption, possibly twice, each time by one year, where it concludes that no viable
technical solution has been developed and that the adverse effect of centrally clearing
derivative contracts on the retirement benefits of future pensioners of impacted
member states remains unchanged.
100. EMIR Refit also provides for a new regime to determine when Financial
counterparties (FC) and Non-Financial counterparties (NFC) are subject to the clearing
obligation, depending on whether their positions exceed or not the clearing thresholds43.
43 The clearing thresholds are defined under Article 11 of Commission Delegated Regulation (EU) No 149/2013: - EUR 1 billion for credit derivative contracts - EUR 1 billion for equity derivative contracts - EUR 3 billion for interest rate derivative contracts - EUR 3 billion for foreign exchange derivative contracts - EUR 3 billion for commodity derivative contracts and others
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101. Differences between the two regimes exist not only with respect to the scope of
application of the clearing obligation but also with respect to the calculation of the
positions. As for the scope, when NFCs conduct the calculation, they are only subject
to the clearing obligation for the OTC derivative contracts pertaining to those asset
classes in respect of which the result of the calculation exceeds the clearing thresholds.
As for the calculation, one important difference is that NFCs only need to include the
OTC derivative contracts which are not objectively measurable as reducing risks,
broadly speaking not entered into for hedging purposes as further specified in the
Regulation, whereas FCs need to include all OTC derivative contracts they enter into
or novate, in accordance with Article 4a(3) and Article 10(3) respectively. It is however
unknown at this stage what the impact of the amendments in Article 4a of EMIR will be
with respect to the numbers of pension funds subject to the clearing obligation.
102. Central clearing however remains the ultimate aim, provided that regulatory and
market developments enable market participants to develop appropriate technical
solutions within that transitional period.
103. European PSAs are indeed expected to clear in the near future, not only
because they are mandated to clear, but also due to regulatory and market forces,
driven in part by clearing obligations, bilateral margining requirements or capital
requirements, expected to contribute to the gradual shift of liquidity to cleared trades.
104. As the 2019 ESMA Annual Statistical Report on EU Derivatives Markets 44
indicates, clearing rates varied throughout 2018 between 57% and 58% of outstanding
notional amount for Interest Rate Derivatives (while on average 4% of the total notional
amount outstanding was cleared by CCPs located in a third country). The ESMA Report
on Trends, Risks and Vulnerabilities No. 2, 201945 also highlights the visible impact of
the regulatory obligations, with an increase of quarterly volumes of interest rate
derivatives cleared during the last two years, from a low of EUR 107tn in 3Q17 to EUR
170tn in 1Q19. Indeed, beyond the clearing obligation, while IM for non-cleared swaps
encourages clearing in certain market segments, regulatory capital requirements for
cleared versus non-cleared swaps as well as the significant benefits flowing from the
ability to net a large and diverse swaps portfolio with a single CCP also constitute great
economic incentives to clear.
105. Respondents indicated that a price difference between the bilateral and cleared
markets is already experienced currently by PSAs. As a way of illustration46, executing
a bilateral 30y interest rate swap with nominal of EUR 50 million can be done at
marginally higher costs than executing a centrally cleared 30y interest rate swap.
However, unwinding a 30y bilateral interest rate swap can easily be 5x-10x as
expensive, particularly if the trade has a significant mark-to-market and if the underlying
CSA accepts bonds as VM. In terms of yield drag, for a PSA whose liabilities have a
duration of 25, which has 40% of its interest rate risk hedged by OTC interest rate
44 https://www.esma.europa.eu/sites/default/files/library/esma50_157_2025_asr_derivatives.pdf 45 https://www.esma.europa.eu/sites/default/files/library/esma_50-165-883_report_on_trends_risks_and_vulnerabilities_no.2_2019.pdf 46 Data provided by a Dutch asset manager during the consultation
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derivatives and the average lifetime an interest rate swap is 5 year, if the cost of
unwinding is 2 times the dv01 of an interest rate swap, the total cost would be 4 bps
per annum.
8 A combination of improved available services
8.1 Pre-conditions for a workable solution
106. There are a number of reasons why no viable solution that would cater for all
the scenarios and for the entire spectrum of PSAs could be provided to date. The main
one has been that technically it is a complex problem to solve, which is why it has
required an extensive effort and collaboration from a range of stakeholders from the
industry and an open dialogue with policymakers.
107. During the last few years, and in particular following the introduction of
roundtable discussions by the Commission, many stakeholders have engaged
extensively on this cash VM issue, exploring various solutions. Obviously, the pension
industry participated, but also the CCPs, banks, other market participants and EU
policymakers.
108. Financial stability is at the heart of the issue: consequently, any solution should
ensure the financial stability of the overall system.
109. In addition, if there is a clear and logical awareness that increasing financial
stability and resilience would necessarily entail some increase in costs for users, one
of the characteristics of the solution looked for is that the impact of PSAs net costs on
pensioners remains reasonable, compared to the status quo.
110. While no single "silver bullet" solution has emerged so far, participants agreed
on a set of required pre-conditions for a workable solution:
• the solution should strike the right balance between the objectives (i) of financial
system resilience and (ii) that the PSAs' participation in central clearing does not
impose a cost on end users which is disproportionate compared to the policy
objectives;
• the solution can only be deemed functional if it is robust enough to be relied upon in
both normal and stressed market conditions.
111. It is also worth highlighting that, even though this report focuses on PSAs, the
challenges highlighted in this report are not specific to PSAs only, but are also faced
by funds, insurance companies, or even other entities indirectly accessing clearing.
This also means that any improvements that will help facilitate clearing for PSAs will
also be of benefit for a wider set of counterparties.
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112. At this juncture, following the various discussions of the Expert Groups and the
responses to the public consultation, we therefore seem to be moving away from the
fact that a 'silver bullet' one-size-fits-all (including PSAs) solution could be fulfilling all
the necessary criteria, including that to be also viable in extreme stressed conditions.
Instead, we seem to be moving towards the optimization by different actors (regulators,
CCPs, clearing members and PSAs as their clients) of a range of solutions already
existing, the addition of which would improve the conditions for this global approach
functioning in the different states of the market that have been considered.
113. This solution, or combination of solutions, would revolve around two axes: one
market-based - enhanced collateral transformation services (via the funding markets)
offered by banks thanks in part to regulatory measures -, and one CCP-based - the
wider offer by CCPs and adoption by PSAs of the sponsored clearing type of
membership for repos.
114. The different components of the global solution are detailed in the following
sections: collateral transformation services by clearing members, market-based repo
and repo clearing via direct or sponsored membership models (respectively in sections
8.2 to 8.4). The regulatory measures suggested by the industry to optimise each part
of the solution are listed in section 8.5.
115. Lastly, as per the first report, some possible approaches have been considered
that could involve central banks, but these are not developed in this report beyond what
had been mentioned before as they are in the remit of central bank mandates to
consider.
8.2 Collateral transformation services by clearing members
116. Relying on collateral transformation services already offered by clearing
members to their direct clients should be central to the solution, alongside the cleared
repo. Banks are well positioned to facilitate the collateral transformation in normal
market conditions and have been providing these services for a long time on a
commercial basis.
117. This option has many benefits: not only it does not require PSAs to increase
their cash buffer, but also it relies on the ancillary service of collateral transformation
already offered by clearing members, and thus would only require a small amount of
adjustment to be implemented as banks are already particularly equipped to provide
such services.
118. Today, insurers are already relying on collateral transformation services in this
way where they typically enter into repo transactions on a regular basis on both liquid
and illiquid collateral. They also enter into liquidity facilities that provide an additional
buffer in case of a stressed scenario. Banks remain well positioned to facilitate the
collateral transformation and have been doing this for a long time.
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119. At present, banks acting as clearing member have indicated that the following
constraints hinder both clearing members and PSAs to support the clearing obligation
for PSAs: the leverage, risk weighted assets, balance sheet size and funding.
120. The way the leverage ratio was originally designed made it less convenient for
banks to provide client clearing services as margins posted by clients could not be used
to offset the amount of the exposure (which would feed into the denominator of the
ratio).
121. The amendment of the Capital Requirement Regulation (CRR-II) has changed
the leverage ratio treatment for client cleared derivatives such as to ‘permit cash and
non-cash forms of initial and variation margin received from a client to offset the
replacement cost and potential future exposure for client cleared derivatives’. This
amendment is expected to help making central clearing more economic in terms of
capital requirements. Further adjustments to the leverage ratio framework would
logically leave more room for clearing members to provide collateral transformation
services.
122. Respondents indicated that with the current regulations, banks will have to hold
additional capital for repo (intermediation) activities resulting in a less liquid repo market
and less favourable rates for PSAs than there would have been if further changes to
the leverage ratio calculation had been introduced. According to these respondents,
without a modification of the calculation methodology of the leverage ratio, repos could
only become a bigger solution for PSAs if these could engage in repos off-market
without a capital charge for banks.
123. Some responses indicated that the current methodology for the leverage ratio
calculation is subject to possible window dressing by certain banks. In these cases, the
outstanding repos at the end of the month, quarter and year are input to the leverage
ratio calculation, while intra month repos are out of consideration. Although repos are
seen as very low risk, the risk during the month is not taken into consideration and
certain banks would limit their repo book over month end to keep the leverage ratio
artificially low.
124. The amendments of the Capital Requirement Regulation in May 2019 as well
as the changes brought by the Basel Committee on Banking Supervision (‘BCBS’) in
June 2019 aimed at changing the leverage ratio treatment of client cleared derivatives
have only been recently implemented, keeping in mind that the Covid-19 turmoil in
financial markets started in February 2020. Some market participants to the
consultation believe that it may also be a question of time for their efficiency to be
noteworthy and that more time is necessary to assess whether this change has been
successful.
125. Expressing their views on the extent to which the constraint on the bank clearing
members’ capital requirements have been eased and now allow for their role of
collateral transformation to be better fulfilled, some asset managers have not witnessed
substantial reductions in the clearing members fees and still see a reluctance to offer
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repo transactions. Market associations on their side refer to the recent COVID-19 crisis
and the issues experienced by the buy-side with respect to banks’ capacity to
intermediate access to the repo market. For both, this as an indication that capital
requirements have not been eased enough.
126. Most respondents to the consultation believe that an improved calibration of the
leverage ratio framework would leave more room to conduct collateral transformation
services that may require less capital and would be part of the global solution. A more
favourable capital treatment for repo/reverse repo would certainly come in support to
stimulate repo intermediation by banks and clearing agents.
127. A limitation of constraints with the aim to ease the pressure on the repo markets
has also been mentioned as a way to provide more availability of bank repo services
to clients.
128. Central counterparties however seem concerned that any further changes to
the leverage ratio could limit its function as a backstop to excessive leverage building.
129. These proposals from the respondents to the consultation would in any case
first need to be further assessed in order to determine their overall impact on financial
stability or on the resilience of banks.
130. The consultation however highlighted that according to PSAs, under stressed
conditions, only a reliable provider of cash which is not balance sheet constrained and
is willing to provide funding would provide sufficient robustness to the solution.
8.3 The market-based repo solution
131. With respect to the size and functioning of the EU repo market, the ICMA ERCC
confirms the observation of a steady growth in the size of the European repo market in
recent years, as highlighted by the semi-annual ERCC European Repo Market
Surveys. This growth can largely be attributed to four main factors: (i) increased
demand for collateral management and collateral transformation due to regulatory
requirements (including Liquidity Coverage Ratio and various clearing/margin rules);
(ii) improved netting efficiencies and balance sheet management by bank
intermediaries; (iii) expansionary monetary policy with a ballooning of banks’ excess
reserves; and (iv) continued growth in the size of the underlying bond markets.
132. As reported by ICMA ERCC in its recent semi-annual survey and special report
on the European Repo Crisis during the COVID-19 crisis in April 2020, European
centrally cleared repo markets are of significant size (EUR 8,310.3 billion as of
December 2019) and provided ample liquidity to market participants during extreme
volatility.
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Figure 3: Growth in the size of EU markets in recent years47
133. The second point of concern relates to the capacity of the European repo market
to absorb a significant increase in demand (whether cleared or bilateral) resulting from
large and sustained margin calls to PSAs.
134. With respect to the suitability of the repo market for PSAs’ needs, Eurosystem
simulations suggest that the repo market has capacity to absorb PSAs’ cash funding
needs. The results of the Eurosystem simulations show that the VM calls on interest
rate swaps held by Dutch PSAs would be in the range of EUR 36bn to EUR 47bn,
resulting in an aggregate cash shortfall of EUR 6bn to EUR 15bn. If it is assumed that
the Dutch PSAs could source their additional cash needs via the repo market, the
estimated cash shortfalls will remain small as compared to the amount of reverse repo
transactions outstanding48, used as a measure to estimate the overall size of the repo
market. Outstanding reverse repo transactions in December 2019 amounted to about
EUR 1.9 trillion. Assuming that the borrowing needs of other euro area PSAs are similar
to those of Dutch PSAs, the cash borrowing needs for all euro area PSAs are likely to
remain below 2% of the overall outstanding reverse repo transactions.49
135. Overall, euro area repo markets have been functioning well over the past years,
even during increased market stress. Volumes in the repo market have been on an
47 Source: ICMA ERCC 48 As measured from the perspective of the MMSR reporting banks 49 PSAs may use only a subset of the repo market as a first step to source liquidity to meet VM calls, in particular the short-term funding market, which according to MMSR data represents around 90% of overall turnover (EUR 550 bn) and 30% of the outstanding repo market funding. It is noted that in times of heightened market volatility, turnover in repo markets might be lower
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increasing trend, despite the high levels of excess liquidity. 50 Some respondents
pointed to the results and implications of the Italian general elections of 2018 which
caused some turmoil in the bond markets with a sharp increase in interest rates, while
repo market volumes and interest rates for Italian and non-Italian collateral remained
stable, indicating a healthy market functioning. Also, during the COVID-19 crisis that
began in late February/ early March 2020, euro area repo markets have shown to be
resilient compared to other market segments in terms of volumes and rates.
136. The latest evidence on quarter-end and year-end developments suggests that
market participants are able to deal with the implications of the window-dressing
constraints on repo markets mentioned above. The reduction in repo trading volumes
over quarter-ends was often matched by a decline in repo interest rates at the period-
end, resulting in an increase in repo borrowing costs for certain types of euro area
collateral.
137. The end-of-year effect on repo rate premia have declined significantly since
2017, mainly driven by increased balance sheet availability, pre-funding by market
participants and a better usage of the Eurosystem cash/securities lending facilities. To
the extent that concerns remain about the reduction of repo market activity at quarter
ends due to window dressing of banks, the BCBS and EU legislators have recently
taken action to limit the incentives for banks to use repos for window dressing purposes.
138. In particular, it was agreed to enhance the disclosure requirements for the
leverage ratio, requiring banks to calculate and disclose their ratios based on quarterly
averages of daily values of their securities financing transactions (SFTs), including
repos. Banks in the EU will have to provide such additional disclosure from 2022
onwards, as well as other averaged exposures to be specified by the EBA.
139. On the offer side, banks servicing access for PSAs to the repo markets will have
a positive impact on the reduction of the liquidity challenges to support the CCP OTC
derivatives markets. Some respondents indicated that some EU banks are developing
solutions to provide such service to their clients. As for the other components of the
global solution, although this might not solve the total liquidity issue for PSAs clearing
OTC derivatives, it would help at least covering a part of the liquidity constraints.
140. The consultation also allowed to bring further input on the existence of a timing
gap between the repo market, where most transactions are done in the morning, and
intraday margin calls, which can happen over the whole day. To solve this timing
mismatch the processing of the variation margin settlement and the settlement of the
repo instrument need to be aligned.
141. A solution has been proposed, consisting in creating a repo instrument that
settles at the time the variation margin needs to be paid is being looked into by multiple
CCPs. Eurex has developed a GC pooling product that settles at the same time as the
50 Daily turnover increased from EUR 450 bn in 2016 to around EUR 650 bn in 2019 according to MMSR data. See Euro money market study 2018: https://www.ecb.europa.eu/pub/euromoneymarket/html/ecb.euromoneymarket201909_study.en.html.
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VM calls for the IRS instrument. The obvious benefit of such a product is that if repo
and derivatives are traded on the same platform it ensures settlement of the VM.
However, trading the two products on different CCPs or even the repo leg on bilateral
basis, will create operational and settlement risk and it will be difficult to ensure timely
payments of the VM. Although this is a very promising option, at this stage it is difficult
to predict whether there will be enough liquidity in the IRS instruments.
8.4 Repo clearing via Direct or Sponsored Membership models
8.4.1 Presentation of the model
142. CCPs recently sought to find ways to open memberships to non-bank
participants to facilitate greater access to the cash and collateral present within the
clearing system, not only allowing for loss mutualization and daily cash margin flow to
remain with an intermediary, but also allowing PSAs and CCPs to have a direct
relationship upon an event of default.
143. CCPs expressed during the consultation that established solutions are already
available for adoption. According to them the initial reason to grant PSAs an exemption
from the clearing obligation has successfully been alleviated by the introduction of an
appropriate, cost effective and reliable technical industry led solution. Providing access
to cleared repo facilities is described as a critical tool by CCPs as it provides not only
access to liquidity but also the appropriate service to transform non-cash into cash
collateral for PSAs’ further usage. Moreover, their view is that it would require a clear
signal from regulators, via regulatory amendments and a defined end-date of the
exemption for PSAs, for this solution to be more widely adopted.
8.4.2 Benefits of the model for PSAs
144. Such models offer PSAs access to repo clearing services as a direct clearing
member while being sponsored into the service by a bank who acts as a sponsoring
agent. PSAs are then able to use the operational services of the sponsoring agent, in
particular to post VM or pay VM directly as and when possible, whilst still benefiting
from all other functionalities which are offered to direct members. Through this clearing
model, members are thus able to limit certain costs of a clearing membership and are
not subject to the bottleneck effect of a concentrated number of banks providing client
clearing services. Moreover, PSAs joining CCPs as Sponsored Members can enable
dealers to free up some of the banks’ balance sheet capacity.
145. This type of clearing membership model is also designed to alleviate some of
the typical membership requirements that have been identified as barriers for PSAs to
access clearing as direct clearing members, such as:
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a) the obligation to post a Default Fund contribution, and the risk mutualisation to
which this gives rise;
b) the liability towards further assessments should the Default Fund be exhausted;
c) the obligations relating to the CCP Default Management Process, such as the
provision of hedges to the CCP to neutralise the defaulter clearing member’s open
risk and the provision of bids to acquire the defaulter’s (hedged) portfolio;
d) a technologically and operationally link to the CCP, for instance to allow multiple
margin calls per day.
146. On this topic, ESMA would like to mention CCP Question and Answer 23 in the
ESMA Q&A document on the implementation of EMIR 51 , which provides certain
clarifications on EMIR and such sponsor models with regards to questions such as who
bears the responsibility to comply with the financial obligations vis-à-vis the CCP. In
particular, the Q&A clarified that although a CCP can establish different clearing models
for different categories of clearing members, clients and indirect clients, EMIR only
envisages clearing through three possibilities of access (being a clearing member,
being a client or clearing through indirect clearing arrangements) and does not
contemplate mixing the status and features of a clearing member and a client or an
indirect client. However, the Q&A also clarifies that a third party can fulfil an obligation
of a clearing member, but that this should not transform the clearing member’s liability
vis-à-vis the CCP.
147. Gaining access to cleared repo facilities through direct or sponsored
membership models can thus help address the issue of the concentration of clearing
members and provide the appropriate tools to turn non-cash into cash collateral for
PSAs’ further usage. Furthermore, coupling the access to cleared repo markets with
the central clearing of interest rate swaps may provide other benefits to PSAs, such as
increasing netting efficiency, decreasing capital requirement or reducing settlement
fails.
8.4.3 Limitations of the model
148. The most obvious limitation is the limited offer, in particular with only one CCP
proposing such model amongst the EU CCPs. Although, taking into account TC-CCPs
or services in development at other EU CCPs, this limitation could be mitigated. It was
however raised to ESMA’s attention that, without EU CCPs being encouraged to swiftly
develop and offer such a service, the expiration of the exemption may lead to an
increased reliance of EU PSAs to some third-country CCPs.
51 Q&A documents including the EMIR Q&A document are available at the following link: https://www.esma.europa.eu/questions-and-answers
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149. Sponsored clearing models are rather sophisticated, only available to large
pension funds and their capacity is to date limited as only a few banks are currently
willing to provide this sponsoring agent service.
150. This set-up still requires the availability of a provider of cash (usually a bank but
not necessarily) and might still have material balance sheet consequences for the
sponsor (bank) which might limit the capacity to offer this service.
151. It has also been highlighted that incentives for a take-up of sponsored access
models should not be limited to the repo market alone, but should be used more widely.
8.4.4 Offer in the EU and current take-up by PSAs
152. Eurex Clearing is offering PSAs to directly access centrally cleared OTC IRS
and the cleared repo market via the clearing model “ISA Direct”. LCH S.A. is also
developing a sponsored clearing model to facilitate the transformation of non-cash
collateral into cash via access to the cleared liquidity pool in RepoClear S.A.
Specificities of repo markets also allow having the Contingent Variation Margin (CVM)
functionality (as opposed to VM) available at some CCPs52, which, by enabling non-
cash to be posted as VM, may ease the challenges faced by PSAs.
153. Despite the limited take up of this new membership models in Europe, a few EU
PSAs along with other significant firms as the pension administrator for multiple Dutch
pension funds PGGM, already use this clearing access model to access the cleared
repo market. Indeed, PGGM Treasury B.V. is a Basic Clearing Member at Eurex
Clearing under the ISA Direct clearing model, allowing PGGM to centrally clear repos.
Intraday and end of day margin calls can be met by pledging securities out of PGGM’s
own CSD account. There is no cash VM call due to the very short tenors of the CCP
cleared repos.
154. Some asset managers with large PSAs as clients expressed the view during the
consultation that this type of membership model is an encouraging concept as it could
provide end-investors, such as PSAs, with sufficient benefits, and thus should be part
of the mix, which together form the global solution.
155. Furthermore, some respondents mentioned that the liquidity of the centrally
cleared repo market has been reliable over the last 15 years. Even in times of market
stress, EU repo markets have been particularly resilient – during the 2008 financial
crisis, the European sovereign debt crises of 2011-2012 and most recently during the
COVID-19 crisis.
156. Additionally, it should be noted that an increased participation of investment
funds, in particular European Money Market (EU MMF) funds, insurance and
52 LCH S.A. for instance
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corporates as traditional cash providers to the centrally cleared repo markets would
likely further increase the availability of cash via cleared repos in the future.
157. It emerges from the responses received from CCPs that further improvements
or refinements to the set-up of the above described services could be envisaged with
the objective to facilitate further the access of PSAs to central clearing.
158. Some of the responses to the consultation brought forward some regulatory
proposals which they argue may increase the attractiveness of centrally cleared repos
for PSAs (and for the buy-side in general). These regulatory change proposals made
by the industry are detailed in the below section.
8.5 Proposed regulatory measures
159. A number of suggestions to amend existing regulations have emerged from the
consultation. They relate to the leverage ratio, capital rules and risk weights. These
industry proposals will require further analysis, especially from a bank regulatory
perspective and in terms of potential impact on bank resilience.
160. Some respondents indicated that an improved calibration of the leverage ratio
framework would leave more room to conduct collateral transformation services that
may require less capital. A more favourable capital treatment for repo/reverse repo
would certainly come in support for stimulating repo intermediation by banks and
clearing agents. However, taking into account the nature of the leverage ratio as a non-
risk based backstop, this specific proposal from some respondents may not fit the
concept of the leverage ratio as a non-risk based backstop nor the fact that it does not
distinguish between different transactions or exposures based in the inherent risk.
While the leverage ratio provisions could potentially be recalibrated as long as the same
level of resilience is maintained, it would appear important to take into accountant that
changes driven by the assessment at hand should not counteract the leverage ratio’s
general nature.
161. An amended and recalibrated methodology where all the repos during the
month are taken into consideration (and not only those outstanding at the end of month,
quarter or year) might be more efficient in overcoming the dip in supply in repo’s at
month end and avoid possible window dressing at the same time.
162. One could also consider establishing a new exposure class for pension funds,
which could lower risk weights for these exposures significantly, improving alignment
with the actual risks these exposures pose to clearing banks.
163. Capital rules (CRR/CRD) may be enhanced to reflect the role of Clearing Agents
providing access for buy-side firms to CCP direct access models and clarify the
treatment of pre- and unfunded default fund contributions, as well as default
management obligations in the leverage ratio and risk weight exposure calculations.
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This could help facilitate the use by buy-side firms (pension funds, insurance
undertaking or asset managers) of the direct access models, some of which were
specifically designed to try and address the capital requirement related constraints
linked to central clearing.
164. PSAs and insurance companies which are direct members of CCPs via direct
access models might be allowed to benefit under Solvency II from the same preferential
treatment that is given to clearing members under CRR II (i.e. look-through criteria for
clients).
165. Cash collateral provided by NFCs to banks acting as clearing members via the
CCP should not be treated less favourably than cash collateral being provided to these
banks via bilateral relationships.
166. In addition, in order to also consider the element of tools that could be adopted
by PSAs to improve their own resilience to funding shocks under stress, the ESRB
flagged in its February 2020 Report ‘Enhancing the macroprudential dimension of
Solvency II’53 that the framework could be revised to better reflect macroprudential
considerations and contribute to reducing systemic risk in the financial sector, including
via the set of liquidity tools for addressing risks stemming from specific activities, such
as hedging with derivatives. The framework for liquidity risk should be enhanced by
better reporting and measurement, stress-testing requirements and Pillar 2 provisions
that enable supervisors to require those that have been identified as having a
vulnerable liquidity profile, to maintain a liquidity buffer, and similar considerations
would also apply to IORP II
167. Other capital changes were proposed with the objective to incentivize further
clearing for the buy-side and address existing regulatory barriers without building
excessive leverage, such as:
a) Counterparty limits of 15% per counterparty for EU MMFs and 20% for
UCITS/AIFs could include a specific treatment for CCPs (as they are buyer and
seller to centrally cleared trades) to avoid breaching these limits too fast;
b) Counterparty risk limits for UCITS/ AIFs could recognize a valid netting sets
across products, i.e. counterparty exposures from derivatives and securities
financing are calculated on a gross basis even if a valid netting agreement
exists. In effect, UCITS currently cannot net exposures when using repo
markets to raise cash to meet cash VM requirements from centrally cleared
derivatives;
c) UCITS/AIFs that have received collateral via title transfer in an SFT could be
allowed to pledge back this collateral to the provider of collateral as long as the
collateral is held bankruptcy remote from the initial collateral provider;
53 https://www.esrb.europa.eu/pub/pdf/reports/esrb.200226_enhancingmacroprudentialdimensionsolvency2~1264e30795.en.pdf
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d) UCITS could be permitted to raise cash via repos in order to meet margin calls
from centrally cleared derivatives.
9 The Covid-19 crisis impact on bilateral and cleared
markets
168. As per the ICMA/ERCC Report ‘The European repo market and the COVID-19
crisis’54 published in April 2020, the general feedback from market participants is that
the EU repo market, for the most part, has ‘held up well’ during the market turbulence
stemming from the global COVID-19 pandemic that began in late February/early March
2020. However, this has not been without some strains.
169. In particular, as the demand for repo has increased, banks’ capacity to
intermediate has remained constrained. While the demand to access the repo market
increased at the peak of the crisis, banks’ capacity or willingness to intermediate that
access did not. Buy-side participants reported an increased reliance on the repo market
as fund outflows drove the need to generate cash against holdings, as well as to meet
margin calls against derivatives positions as volatility increased. However, it would
seem that banks struggled to keep pace with client demand. Many reported limiting
business to top tier clients, with no capacity for new business. Banks further report that
in light of the heightened volatility, it was more a case of risk weighted assets (RWA)
limits becoming the binding constraint on business, rather than the Leverage Ratio,
particularly for one-directional business flows (such as net borrowers of cash, which
PSAs typically are).
170. While the analysis assuming a 1% rate move might seem conservative, spikes
in rates to almost that level were witnessed during the Covid-19 market stress: over
just one week, the EUR 20-year swap real rate increased by circa 0.63%, and over two
weeks, the French 20-year government bond yield increased by approximately 0.90%.
This can be seen as a classic case of a stressed period where all asset classes were
impacted. A sell-off of all risk assets (equity and credit) and even high-quality
government bonds, and dislocations of currency markets, led to sudden VM calls
across a number of investment portfolios for many market participants. This increased
demand for cash, and while the repo markets functioned well for intra-bank
transactions, caused some issues for the buy-side.
171. In contrast, the cleared markets operated efficiently and effectively during the
recent market volatility related to the COVID-19 pandemic, providing continued access
to derivatives products. Spikes in margin calls, as a result of increased volatility, have
however been reported.
54 https://www.icmagroup.org/assets/documents/Regulatory/Repo/The-European-repo-market-and-the-COVID-19-crisis-April-2020-270420v2.pdf
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10 Access to alternative emergency liquidity arrangements
172. In the first report, there was a brief mention of the eventuality of alternative
arrangements that might involve the central banks and it is recalled that it was
mentioned for completeness.
173. However, it is ESMA’s view that central banks are exclusively competent for the
assessment of the need, the potential decision and the establishment of central bank
facilities and for the interpretation of their intended usage. Therefore, there is no need
for ESMA to opine on such solutions relating to central bank facilities and those will not
be discussed in this report55. The Eurosystem took advantage of this consultation to
reiterate its readiness to formally engage with relevant stakeholders on issues falling
within its mandate.
174. However, in order to accurately reflect the opinions put forward by the
stakeholders in the context of the discussions in the Commission Expert Group on
PSAs, the proposal made is still mentioned in this report. It is important to highlight that
such proposal is neither endorsed nor supported by the Eurosystem at this stage.
175. In previous discussions, market participants referred to the lack of certainty on
the good functioning of the repo market in stressed times and thus advocated for a
backstop role for central banks, whereby central banks would provide an access to
liquidity to a regulated entity such as banks or CCPs for the benefit of providing access
to cash to PSAs, for them to then be able to meet the VM calls for their OTC derivatives
under stress.
11 Conclusion
176. Since the temporary exemption was first granted when EMIR entered into force
in 2012, some solutions to mitigate the challenges faced by PSAs, as described in this
report, have been explored. Individually, such solutions would not appear to be able to
support PSAs in normal times and in stressed times. However, together they may be
able to support PSAs at all times.
177. At this point, it is very unlikely that after so many efforts from all stakeholders
and regulators since the start of the exemption a new and never thought of ‘silver bullet’
solution emerges at this stage.
55 Regarding this aspect please refer to the European Commission’s paper assessing whether viable technical solutions have been developed for the transfer by pension scheme arrangements of cash and non-cash collateral as variation margins and the need for any measures to facilitate those viable technical solutions (COM/2020/574 final).
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178. Instead the solution towards which we are moving seems rather to be the
optimisation by different actors (regulators, CCPs, clearing members) of already
existing solutions. Although some of these existing solutions need to be further
developed or might need regulatory consideration, their addition should provide the
conditions for PSAs to be able to clear and meet variation margin calls in all states of
the market that have been considered in the discussions.
179. However, the progress for adopting these solutions and ensuring readiness
would still require some more time, and thus ESMA is of the view that a possible
extension by the Commission of the temporary exemption would be beneficial to allow
time to finalise these discussions and the timely implementation of the solutions.
180. Depending on whether the Commission decides to extend or not the
exemption, it might help to try and give some visibility and aim for a defined end date
for when clearing would be required as to ensure continued and managed progress on
the readiness process.
181. While market-based tools like collateral transformation by clearing members or
the repo market have demonstrated to date being able to support PSAs in normal times,
the industry suggested that these tools are not guaranteed to work in extreme stressed
markets unless certain changes are introduced, including potentially regulatory
changes such as with respect to capital requirement rules. These suggested changes
however require a further analysis and the involvement of bank regulatory and
supervisory authorities.
182. Solutions available for client clearing or other forms of CCP access, such as
sponsored access, by addressing many of the issues raised by PSAs, seem promising,
and moreover potentially beneficial to other users of derivatives beyond PSAs. Some
European PSAs already make use of sponsored access models to access the cleared
repo markets, as European centrally cleared repo markets are of a significant size and
have provided liquidity to market participants even in times of extreme market stress.
Here as well, to be available to all PSAs some adjustments might need to be
introduced, at CCPs and clearing members and potentially also in conjunction with
some regulatory measures, the latter still requiring further assessment and ultimately
agreement by regulatory and supervisory authorities.
183. Given that some of the issues faced by PSAs are not specific to PSAs, being
instead common to all less sophisticated or simply less active entities than the bigger
ones engaged in clearing, such as investment funds or insurance companies which do
not benefit from a similar exemption under the EMIR framework, these services could
be further adapted to also cater for the specificities of PSAs’ needs.
184. For a thorough analysis and potential development of these operational
changes and/or regulatory adjustments to be effective, the current exemption elapsing
in June 2021 does not allow sufficient time. It is therefore ESMA’s view that the
temporary exemption could be renewed by one year as possible under EMIR, i.e. up
to June 2022.
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185. At the same time, ESMA, and more broadly the regulators involved in this topic,
reiterate the view that exemptions, or extensions of exemptions, from the clearing
obligation should be carefully considered, because of the strong conviction of the
benefits of a broad adoption of the clearing obligation, including for PSAs. As a result,
all efforts should be made to then avoid a further extension of the temporary exemption.
12 Next steps
186. ESMA has now submitted this second report to the Commission, which would
serve as input for the Commission’s own report.
187. As explained in the report, ESMA is of the view that more time is needed to
make sufficient progress with the implementation of this mixture of solutions and thus
that an extension by one year by the Commission of the temporary exemption, as
provided for in EMIR Refit, would be beneficial.
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13 Annex - EMIR Refit 56 articles relevant to the Clearing
Obligation for Pension Scheme Arrangements
Article 1(24)(c) states that paragraph 2 of Article 85 of EMIR on developing technical solutions
for the transfer by pension scheme arrangements of non-cash collateral as variation margin
should be replaced by the following paragraphs:
Box 1: Article 1(24)(c) of EMIR Refit
2. By 18 June 2020, and every 12 months thereafter until the final extension referred to in the
third subparagraph, the Commission shall prepare a report assessing whether viable technical
solutions have been developed for the transfer by pension scheme arrangements of cash and
non-cash collateral as variation margins and the need for any measures to facilitate those
viable technical solutions.
ESMA shall, by 18 December 2019, and every 12 months thereafter until the final extension
referred to in the third subparagraph, in cooperation with EIOPA, EBA and the ESRB, submit
a report to the Commission, assessing the following:
(a) whether CCPs, clearing members and pension scheme arrangements have undertaken an
appropriate effort and have developed viable technical solutions facilitating the participation of
such arrangements in central clearing by posting cash and non-cash collateral as variation
margins, including the implications of those solutions on market liquidity and procyclicality and
their potential legal or other implications;
(b) the volume and the nature of the activity of pension scheme arrangements in cleared and
non-cleared OTC derivatives markets, within each asset class, and any related systemic risk
to the financial system;
(c) the consequences of pension scheme arrangements fulfilling the clearing requirement on
their investment strategies, including any shift in their cash and non-cash asset allocation;
(d) the implications of the clearing thresholds specified pursuant to point (b) of Article 10(4) for
pension scheme arrangements;
(e) the impact of other legal requirements on the cost differentials between cleared and non-
cleared OTC derivative contracts, including margin requirements for non-cleared derivatives
and the calculation of the leverage ratio in accordance with Regulation (EU) No 575/2013;
56 Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 648/2012 (known as ‘EMIR’) as regards the Clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories --- OJ L 141, 28.5.2019, p. 42–63
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(f) whether any further measures are necessary to facilitate a clearing solution for pension
scheme arrangements.
The Commission may adopt a delegated act in accordance with Article 82 to extend the two-
year period referred to in Article 89(1) twice, each time by one year, where it concludes that
no viable technical solution has been developed and that the adverse effect of centrally
clearing derivative contracts on the retirement benefits of future pensioners remains
unchanged.
CCPs, clearing members and pension scheme arrangements shall make their best efforts to
contribute to the development of viable technical solutions that facilitate the clearing of OTC
derivative contracts by such arrangements.
The Commission shall set up an expert group composed of representatives of CCPs, clearing
members, pension scheme arrangements and other relevant parties to such viable technical
solutions to monitor their efforts and assess the progress made in the development of viable
technical solutions that facilitate the clearing of OTC derivative contracts by pension scheme
arrangements, including the transfer by such arrangements of cash and non-cash collateral as
variation margins. That expert group shall meet at least every six months. The Commission
shall consider the efforts made by CCPs, clearing members and pension scheme
arrangements when drafting its report pursuant to the first subparagraph.
Article 1(26) states that paragraph 1 of Article 89 of EMIR on a transitional clearing exemption
for pension scheme arrangements should be replaced by the following paragraph:
Box 2: Article 1(26) of EMIR Refit
Until 18 June 2021, the clearing obligation set out in Article 4 shall not apply to OTC derivative
contracts that are objectively measurable as reducing investment risks that directly relate to
the financial solvency of pension scheme arrangements, and to entities established to provide
compensation to members of such arrangements in case of default.
The clearing obligation set out in Article 4 shall not apply to OTC derivative contracts as
referred to in the first subparagraph of this paragraph entered into by pension scheme
arrangements from 17 August 2018 until 16 June 2019.